Five simple rules to become a better investor

Investors aren’t bad at investing; they’re often overwhelmed and exhausted by too many decisions. Our special contributor and Daily Telegraph columnist David Stevenson explores why poor financial behaviours are often driven by decision fatigue rather than lack of skill, and explains how greater discipline can help improve long-term outcomes.

Over 100 years ago, a statistician called Francis Galton attended a county fair in Plymouth where visitors were competing to estimate the slaughtered and dressed weight of an ox. Galton collected and analysed hundreds of eligible entries from the competition, including butchers and farmers who were highly expert in judging cattle, as well as many ordinary visitors guided only by their hunch. The middlemost (median) estimate was 1,207 pounds for the crowd. The actual dressed weight of the ox was 1,198 pounds – meaning the crowd was accurate to within 0.8% of the true value.

Roughly a hundred years later, another academic, this time a psychology and political science professor at the University of Pennsylvania, called Philip Tetlock, decided to tackle the wisdom of the crowd and the power of experts.

To test his theory, Tetlock pulled together 284 highly credentialed experts (economists, intelligence analysts, political scientists) and then tracked the performance of their individual predictions about the future. It won’t come as a surprise to learn that these experts were highly confident in their insights and largely dismissed the opinions of the crowd, aka the common person. Over two decades, Tetlock tracked 82,361 individual predictions they made about the future.

The US academic famously concluded that the average expert was roughly as accurate as a “dart-throwing chimpanzee.” The highly credentialed experts were routinely outperformed by simple statistical algorithms, and more importantly, by the aggregated guesses of well-informed laypeople. Tetlock found an inverse correlation between an expert’s fame/confidence and their actual accuracy.

This detour into the world of crowd psychology is meant as an opening insight into the war that is constantly waged against private investors, who, as many investment professionals see them, are repeat losers who need all the expert advice they can get (and pay for). To be fair to the experts, as we will discover, there is a mountain of evidence that suggests most, though not all, private investors ‘underperform’ their professional peers, but that’s largely a function of a series of behavioural biases that can be corrected, modified and managed.

So, before we look at the evidence for the ‘expert’ prosecution, let’s start with the good news: private investors, as a crowd, can be very successful. The UK online trading platform Interactive Investor regularly tracks its investors (via the Private Investor Performance Index) and finds they frequently outperform professional fund managers and portfolio asset allocators. Some academics have also rallied behind the idea that investors can beat the professional experts, notably a paper from 2003 and revised in 2018 (Coval, Hirshleifer and Shumway – Can Individual Investors Beat the Market?, 2021) which used individual US brokerage account data. This study documented persistent superior trading performance among a subset of individual investors, especially those skilful individual investors who can exploit market inefficiencies to earn abnormal profits above and beyond any gains available from well-known strategies. 

But I’d also be lying to you if I said that the great weight of academic and industry research backs up the wisdom of the crowds. Sadly, the evidence suggests that, on average, private investors do ‘underperform’. I’ll quickly spin through the evidence before pondering what this data tells us.

Amongst the highlights/lowlights, depending on your point of view, in research, there’s the definitive study by Barber and Odean (2000), published in the Journal of Finance. This found that the most active traders among 66,465 US brokerage households earned an annual return of just 11.4%, against a market return of 17.9%. The least active investors, by contrast, earned 18.5% net of costs – a gap of more than seven percentage points. The culprit, the authors argued, was overconfidence: investors systematically overstated the quality of their information and traded on it at their own expense.

Another Barber and Odean study, this time from 2001, called “Boys Will Be Boys,” analysed common stock investments of more than 35,000 households from February 1991 to January 1997. Men traded 45% more than women and earned annual risk-adjusted net returns that were 1.4 percentage points lower. Between single men and single women, the gap was starker still: single men traded 67% more and underperformed by 2.3 percentage points annually.

Many experts point to a brilliant paper based on Swedish household data (Calvet, Campbell and Sodini, 2007), which identified two reasons for underperformance, namely under diversification and non-participation in risky asset markets. The authors found that financially sophisticated households invested more efficiently, but also more aggressively, and on net incurred higher return losses from underdiversification.

In terms of industry research, Morningstar regularly measures the difference between a fund’s reported total return and the actual returns earned by the fund’s investors. Recent estimates put this global annual behaviour gap at roughly 1.15% to 1.22% per year over a 10-year period. This implies that retail investors forgo approximately 15% of their potential returns simply by trying to time the market, rather than holding their positions steadily as institutional asset managers do.

The industry gold standard is a report by an American organisation called Dalbar inc. Its last annual report (Quantitative Analysis of Investor Behavior report) from 2025 found that the average equity investor earned just 16.54% in 2024, compared to the 25.02% return of the S&P 500 (the market index tracking the stock performance of the 500 leading US companies). The 848-basis-point lag represented the second-largest investor performance gap of the past decade. The report found that this contrast in performance “reflects differences in how investors respond to market conditions across asset classes – and how behavioural factors shape outcomes in more ways than one”.

A legion of behavioural biases

The point of many of these studies is not to say that private investors are always wrong, or that they can’t outperform or even that they are stupid. Rather, study after study has shown that the ‘average’ investor exhibits a series of biases, identified in mass psychology research, that undermine their returns. Amongst the biases that study after study have shown are:

• Overconfidence: overestimating skill and information precision, leading to excessive trading.
• Disposition effect: selling winners too quickly, holding losers too long.
• Loss aversion and narrow framing: focusing on short‑term losses more than long‑term distribution of outcomes.
• Herding and social influence: trading with the crowd, trend‑chasing.
• Home bias and familiarity bias: overweighting domestic and familiar assets.
• Mental accounting: segregating pots of money and risks in non‑optimal ways.
• Anchoring: fixating on purchase prices, past peaks, or salient round numbers.

Empirical work across countries finds these biases more pronounced among private than institutional investors, though institutions are not immune. A recent mixed‑methods study on retail investors, for example, found overconfidence, herding, mental accounting, anchoring, and loss aversion all significantly associated with mistakes in investment decision‑making.

It’s worth digging a little deeper into these biases, starting with the first academic study I mentioned by Barber and Odean. They analysed trading records for those US brokerage accounts and found that investors demonstrated a clear bias towards realising gains rather than losses. The stocks investors sold for a gain went on to outperform the stocks they held for a loss by around 3.4% over the following year – a finding that underscores just how costly the bias is in practice.

Another problem identified by US academics is that individual investors face a vast stock-selection problem, and, as a result, many rely on decision shortcuts. Rather than searching systematically, many investors consider only stocks that first catch their attention – those in the news or with large price moves.

This has been backed up by research in the UK by the regulators, the Financial Conduct Authority (FCA), which found that non-advised UK investors used rules of thumb and cognitive shortcuts. The research identified three broad consumer types:confident self-starters, eager learners and hesitant hopefuls – and found that as investors gained experience, they generally adopted more considered approaches, though this was not universal.

Another core problem is home bias, especially among US and UK investors, who hold portfolios heavily tilted toward domestic equities. Familiarity reduces perceived risk, encouraging concentrated exposures in local markets or industries even when global diversification would improve risk‑adjusted returns. This leads to over‑exposure to domestic macro- and policy-related risks and under‑exposure to international diversification benefits.

I’d also draw attention to a cracking study by Clare and Motson (Bayes Business School / City, University of London), which looked at the UK mutual fund industry and quantified the exact cost of poor timing decisions. They found that, on average, UK retail investors lost performance equivalent to roughly 1.2% per year due to sub-optimal, wealth-reducing timing. Crucially, when Clare and Motson analyzed institutional fund flows, they found the performance gap was virtually 0.00% per year. The wealth destruction caused by buying high and selling low was entirely isolated to the retail sector. In simple terms, too many of us poorly time our investment decisions.

The experts are flawed too

OK, so I think you get the message, but before we discuss what you can do about these behaviour-based biases, I think it is important to add one crucial caveat: the experts get it wrong as well, all too frequently. Active fund managers, for instance, consistently underperform their benchmarks. For instance, the SPIVA Scorecard, from S&P Dow Jones, is the industry standard for the active-versus-passive debate. In various reports, it has been found that over the 20-year period from 2005 to 2024, 94.1% of all US domestic funds underperformed the S&P 1500 Composite Index. On a risk-adjusted basis, the performance was even worse, with 97.3% of domestic funds underperforming. Less than half of domestic funds even survived the full 20-year period.

This finding has been echoed in another UK study (Cuthbertson, Nitzsche and O’Sullivan – Journal of Empirical Finance, 2008) which looked at UK based funds, unit trusts, and found around 0 to 5% of top-performing UK and US equity mutual funds have truly positive alpha performance after fees, and around 20% of funds have truly poor alpha performance, with roughly 75% of active funds which are effectively zero-alpha funds. Key drivers of relative performance are fees, expenses and turnover. There is little evidence of successful market timing.

Another more focused insight is that the average fund manager runs a portfolio that probably amounts to between £500m and £1 billion. If they make a big change to their portfolio, it can be ‘awkward’ to manage the resulting market liquidity, distort the trading price, or even slow down a trade altogether. Also, because of their fund size, these professional managers tend to avoid a huge swathe of the market represented by smaller market-cap or value companies, simply because they can’t get enough liquidity to make the trade. Private investors face none of these challenges.

Become a better investor

It’s hard not to conclude from the mountain of research that private investors, in aggregate, underperform, primarily because of excessive trading, poor timing and concentrated, poorly diversified portfolios i.e poorly managed behaviour that can be overcome with some simple rules.

But professional fund managers also underperform the market in aggregate – by smaller margins, but still reliably so, and almost entirely because of fees and costs. Genuine persistent skill exists in both populations, but it is rare.

So, how might private investors think about investing differently? I’d suggest five simple rules:

1)    Don’t be overconfident, and do not completely rely on mental shortcuts. Do your own research (DYODD – do your own due diligence), be well read, informed and always think through what could go wrong with your investment decisions. Also be incredibly careful about what you read, who you listen to and who you respect in terms of guidance, perhaps starting with social media which is full of pratfalls and dangers. If that all seems like too much of an ask, then get advice and get a professional to do it all for you.

2)    Do less, not more, and don’t spend much time trying to time markets. It’s usually a fool’s errand to constantly overtrade, and over time, market swings: even the professionals struggle with this challenge. If you have a long enough time frame for investing, stay invested and make regular, steady contributions. If you do feel the need to be more speculative, split your portfolio into a core portfolio, which you leave alone, and a satellite portfolio in which you are more tactical.

3)    Make sure you are properly diversified and don’t fall for the home bias trap. That also means you might be super careful about being too exposed to dominant market narratives i.e the US, Artificial Intelligence and technology. Sensible diversification is always about managing the downside risk as much as it is about the upside.

4)    Be supremely aware of cost and how excessive fees destroy your long-term returns. Cut costs by using cheaper funds and don’t fall for the siren call of expensive alpha fund management – it usually doesn’t deliver, and if I’m honest, most of the really consistently successful hedge fund managers, for instance, are not open to private investors anyway!

5)    If you are a more active investor, be aware of your limitations, have a fixed set of rules you stick to and crucially don’t make the common mistake of sitting tight on your losses and cutting your winners too quickly.

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